Question

Due Thursday Respond to the following in a minimum of 175 words: Discuss how competitive markets determine the wage rate and the quantity of labor that should be employed. Due Monday

Answer 1

In a perfectly competitive market, wages and labour employment is determined by the intersection of the labour demand and labour supply curve. Here the demand for labour is governed by the marginal revenue product of labour which is equal to the value of marginal product of labour if the firm employing the labour is perfectly competitive.

The supply of labour is determined by the size of the population, number of able bodied people willing to work, job requirements and a variety of socio cultural factors. It is difficult to determine the effect of increase in wage on the labour supply. Increase in wages may boost people to work more implying a positive relationship between the two whereas higher wages may prompt people to trade-off labour for leisure indicating a negative relationship. It is however generally held that the total supply of labour rises up to a certain wage level and then it bend backwards, thus shape of the labour supply curve is backward bending. However the supply of labour in a particular sector slopes upwards, as wages in this industry goes up people will migrate to this sector.

The demand for labour is determined by the value of marginal product (VMP) of labour. A profit maximizing firm equates the value of their marginal product of labour to wages. If the VMP of labour exceeds the wages, the firm can expand it's profit by employing more labour and if VMP of labour falls short of wages firms are better off cutting down on labour employed. Thus to maximize profit firms equate the VMP of labour to the wages. In case of two inputs the firm equates the ratio of the marginal product of the inputs to the factor price ratio. Thus wages are equal to the VMP of labour.

The wages are determined by the intersection of the labour demand and labour supply curve. In the figure drawn in the picture attached below it can be seen that at wage rate OW the labour market clears. At a higher wage the labour supplied exceeds the labour demand creating involuntary unemployment which pushes the wages back to OW. At wages below OW labour demand exceeds labour supplied which creates an upward pressure on the wages driving them upwards.

wage rate Unemplgymant excess denand laboun

It is also important to note that competitive markets may earn positive profits in the short run. In short the average revenue product of labour exceeds the wages enabling the firm to earn super normal profit. In the long free entry of entrepreneurs leads to an increase in the demand for labour thus driving up their wages. The higher wage rate thus reduces profits and hence firms can earn only normal profit in the long run in competitive markets.

Thus in the long equilibrium between demand and supply of labour is established at the level where the wage rate of labour is equal to both the value of marginal product and the average revenue product of labour.